Uncertainty, Access to Debt, and Firm Precautionary Behaviour

okt. 08, 2020

The contemporary world is filled with uncertainty surrounding issues that include, but are not limited to, the coronavirus pandemic and trade wars between USA and China. Uncertainty is considered to be a major driver of recession in macroeconomic literature, due to the fact that when uncertainty increases companies tend to postpone investments and hence has a profound impact on firms’ cash flow. In their paper ‘Uncertainty, Access to Debt, and Firm Precautionary Behaviour’ forthcoming in the Journal of Financial Economics, Mariassunta Giannetti, Professor at the Stockholm School of Economics, Janet Gao, Assistant Professor at Indiana University Kelley School of Business and Giovanni Favara, Assistant Director, Division of Monetary Affairs at Federal Reserve Board consider how access to financial markets and particularly debt markets can help to mitigate the negative effects of various uncertainty shocks.

 

According to Professor Giannetti, who is also a CEPR research fellow and a research associate of the ECGI, uncertainty has many drivers. Such as critical uncertainty or geopolitical uncertainty, which would include shocks like the Covid-19 pandemic. If there are increases in geopolitical risk or political uncertainty, firms tend to react and as a result policy makers may wish to counteract the reaction through various corporate policies. To that end, an efficient way of providing a sort of insurance could potentially be to favour access to debt markets. At the same time, when strengthening creditors’ rights it also means that creditors more easily can appropriate assets, which could both produce positive and negative outcomes, the Professor underscores.

 

Next, uncertainty is a pressing issue in contemporary academic literature, particularly in macroeconomics. The paper’s primary focus is on microeconomic aspects of uncertainty, but could also lend explanations to the underlying mechanisms of uncertainty and why it matters. Professor Giannetti highlights the importance of studying uncertainty, partially considering the state of the world and, in part because certain macroeconomic theories assume that uncertainty is an inevitable phenomena. In contrast, another class of theories propose that uncertainty actually matters since it decreases the level of risk-sharing in the economy, which potentially provides scope for policy makers to intervene.

 

In the paper, the research team offer evidence for the latter class of macroeconomic theories. Through detailed investigation of changes in laws that in some US states favour access to debt markets for some firms, they compare how firms react to different types of uncertainty shocks. They observe that firms who act in environments in which creditors’ rights are protected through favouring access to debt markets become less responsive to uncertainty shocks. As a consequence, it seems that these firms continue to invest in more research development and other intangible assets, whilst firms with less access to debt markets tend pile up on cash to shield from uncertainty. Hence it seems that firms know that they have access to debt markets in case cash flow drops leverage that avenue as a type of insurance.

 

To that end, the paper presents the potential benefits of strengthening creditors’ rights and subsequently why this matters for the economy more broadly. Additionally, if there are institutions that can provide some form of insurance it could potentially generate smoother business cycles. Above all, it adds quintessential insights to the body of knowledge when considering distinct classes of macroeconomic theories which fail to highlight financial friction, assuming that uncertainty centers around technology and can therefore not be mitigated. Instead, the Professor says, uncertainty matters to a significnat degree because more than atnything else it highlights how much risk society wishes to bear.

 

About Mariassunta Giannetti 

Professor Giannetti has been at SHoF since its establishment in 2011. Her research is in financial intermediation and corporate governance. Broadly, her interests include how different institutional arrangements can favour better allocation of resources in the economy and mitigate the negative effects of shocks. Professor Giannetti studies how financial intermediates should be designed, various kinds of laws that affect the way in which firms operate in the economy, contract structures, among other things. She teaches a PhD course in research design and international finance for master students, for which her objective is to allow students in their professional career to be aware of influential finance research.